Efficiency Ratio (Activity Ratio)
Efficiency ratio, also known as activity financial ratios, are used to measure how well a company is utilizing its assets and resources.
Efficiency Ratio Formulas
Receivable Turnover = Net Credit Sales ÷ Average Accounts Receivable
Measures the efficiency of extending credit and collecting the same. It indicates the average number of times in a year a company collects its open accounts. A high ratio implies efficient credit and collection process. A high ratio implies either that a company operates on a cash basis or that its extension of credit and collection of accounts receivable is efficient. While a low ratio implies the company is not making the timely collection of credit.
Days Sales Outstanding = 360 Days ÷ Receivable Turnover
Also known as “receivable turnover in days”, “collection period”. It measures the average number of days it takes a company to collect a receivable. The shorter the DSO, the better. Take note that some use 365 days instead of 360.
Inventory Turnover = Cost of Sales ÷ Average Inventory
It represents the number of times inventory is sold and replaced. Take note that some authors use Sales in lieu of Cost of Sales in the above formula. A high ratio indicates that the company is efficient in managing its inventories.
Days Inventory Outstanding = 360 Days ÷ Inventory Turnover
Also known as “inventory turnover in days”. It represents the number of days inventory sits in the warehouse. In other words, it measures the number of days from purchase of inventory to the sale of the same. Like DSO, the shorter the DIO the better.
Accounts Payable Turnover = Net Credit Purchases ÷ Ave. Accounts Payable
Represents the number of times a company pays its accounts payable during a period. A low ratio is favored because it is better to delay payments as much as possible so that the money can be used for more productive purposes.
Days Payable Outstanding = 360 Days ÷ Accounts Payable Turnover
Also known as “accounts payable turnover in days”, “payment period”. It measures the average number of days spent before paying obligations to suppliers. Unlike DSO and DIO, the longer the DPO the better (as explained above).
Operating Cycle = Days Inventory Outstanding + Days Sales Outstanding
Measures the number of days a company makes 1 complete operating cycle, i.e. purchase merchandise, sell them, and collect the amount due. A shorter operating cycle means that the company generates sales and collects cash faster.
Cash Conversion Cycle = Operating Cycle – Days Payable Outstanding
CCC measures how fast a company converts cash into more cash. It represents the number of days a company pays for purchases, sells them, and collects the amount due. Generally, like operating cycle, the shorter the CCC the better.
Total Asset Turnover = Net Sales ÷ Average Total Assets
Measures overall efficiency of a company in generating sales using its assets. The formula is similar to ROA, except that net sales is used instead of net income.
Examples
FINANCIAL SUMMARY OF HELLO Ltd.
Following is the table representing the financial summary of Hello Ltd.:
| PARTICULARS | 2020 (IN MILLION USD) | 2019 (IN MILLION USD) |
| Net Sales | 39,540 | 34,922 |
| Cost of Goods Sold | 14,056 | 12,586 |
| Accounts Receivable | 3,821 | 3,989 |
| Average Accounts Receivable | (3,821+3,989)/2=3,905 | |
| Accounts Payable | 869 | 786 |
| Average Accounts Payable | (869+786)/2=827.50 | |
| Current Liabilities (A) | 13,858 | 13,358 |
| Current Assets (B) | 35,699 | 31,574 |
| Working Capital (B)-(A) | 35,699-13,858=21,841 | 31,574-13,358=18,216 |
| Average Working Capital | (21,841+18,216)/2=20,028.5 | |
| Inventories | 1,235 | 1,322 |
| Average Inventory | (1,235+1,322)/2=1278.5 | |
| Fixed Assets | 4,151 | 3,893 |
| Average Fixed Assets | (4,151+3,893)/2=4,022 | |
| Total Assets | 58,734 | 53,340 |
| Average Total Assets | (58,734+53,340)/2=56,037 | |
With the help of above summary, we have calculated the efficiency ratios and they are presented as below. This will give a fair idea on how to calculate the efficiency ratios.
| RATIO CALCULATION FOR THE YEAR 2020 | |||
| EFFICIENCY RATIOS | FORMULA | CALCULATION | RATIO |
| Accounts Receivables Turnover | Sales/Average Accounts Receivables | 39,540/3,905 | 10.13 |
| Average No. of Days Receivables Outstanding | 365/Accounts Receivables Turnover | 365/10.13 | 36.03 Days |
| Inventory Turnover | Cost of Goods Sold/Average Inventory | 14,056/1278.5 | 11 |
| Average No. of Days Inventory in Stock | 365/Inventory Turnover Ratio | 365/11 | 33.18 Days |
| Accounts Payables Turnover | Total Purchases/Average Accounts Payables | 13,969/827.50 | 16.88 |
| Average No. of Days Payable Outstanding | 365/Accounts Payables Turnover | 365/16.88 | 21.62 Days |
| Working Capital Turnover | Sales/Average Working Capital | 39,540/20,028.5 | 1.97 |
| Fixed Asset Turnover | Sales/Average Fixed Assets | 39,540/4,022 | 9.83 |
| Total Assets Turnover | Sales/Average Total Assets | 39,540/56,037 | 0.71 |
Sources: PinterPandai, Corporate Finance Institute